The Markets in Financial Instruments Directive (MiFID) is one of the cornerstones of EU financial services law setting out which investment services and activities should be licensed across the EU and the organisational and conduct standards that those providing such services should comply with.
Following technical advice received from the European Securities and Markets Authority (ESMA) and a public consultation, in 2011 the European Commission published legislative proposals to amend MiFID by recasting it as a new Directive (MiFID II1) and a new Regulation (MiFIR2). The European Parliament and the Council of the EU (the Council) have been debating the text since then, taking into account the efforts of the financial services and wider industry to influence the direction of certain provisions. Following informal agreement between the EU institutions, in February 2014 the Council published the final compromise texts of MiFID II and MiFIR and these were subsequently approved by the Permanent Committee of Representatives. These texts, on which this briefing is based, must now be approved by the European Parliament to enable the Council to adopt them. The European Parliament is expected to consider MiFID II and MiFIR during its 10 to 13 March 2014 plenary session.
The deadline for implementation of MiFID II by Member States and the time at which the provisions in MiFIR will start to apply are not yet known although they are not expected to be until the end of 2015 at the earliest. ESMA and the other European authorities need to develop the numerous technical standards intended to flesh out some of the requirements in more detail before that time. ESMA has indicated that a discussion paper on the technical standards will be published shortly after the European Parliament approves the final texts. Following the responses to the discussion paper, ESMA will publish a consultation paper on draft technical standards later in 2014 or early in 2015.
This briefing considers how MiFID II and MiFIR will affect participants in commodities markets, particularly those that trade commodity derivatives and emission allowances.
The provisions in MiFID II and MiFIR relating to commodity derivatives aim to ‘improve oversight and transparency of commodity derivative markets in order to ensure their function for hedging and price discovery, as well as in light of developments in market structures and technology, in order to ensure fair competition and efficient markets’. The changes also reflect the G20 agreement to improve the regulation, functioning and transparency of financial and commodity markets to address excessive commodity price volatility.
Extended scope of Financial Instruments
Emission allowances will become financial instruments for the purposes of MiFID II. However, it should be noted that the provisions on position limits and position management controls for derivatives in MiFID II and MiFIR refer to ‘commodity derivatives’, which does not include derivatives on emission allowances.
The definition of derivatives in EMIR3 also refers back to MiFID. Spot emission allowances will not be in scope of the various EMIR obligations, but derivatives on emission allowances will continue to be.
Physically settled commodity derivatives and REMIT wholesale energy products
The types of physically settled commodity derivatives covered in Section C(6) of Annex 1 to MiFID will be extended to those traded on an organised trading facility (OTF). However, there is a carve out for wholesale energy products (as defined in Article 2(4) of REMIT4) that are traded on an OTF and which must be physically settled. Such REMIT contracts will not be derivatives for the purposes of EMIR either.
MiFID II also contains a transitional provision in relation to the applicability of the EMIR clearing and collateralisation obligations to derivatives relating to coal or oil that are traded on an OTF and which must be physically settled. Non-financial counterparties exceeding the clearing threshold or those entities which become authorised as a result of MiFID II, will not have to clear or collateralise trades in such derivatives for a period of 42 months after the entry into force of MiFID II. In addition, for the duration of the transitional period, non-financial counterparties will not have to include such contracts in their clearing threshold calculations. All other EMIR obligations, including the other risk mitigation obligations and the reporting obligation, will not be subject to the transitional period.
Commodity and exotic derivatives ‘having the characteristics of other derivative financial instruments’
Regulatory technical standards are to be published giving guidance on which physically settled commodity and exotic derivatives should be considered to have the ‘characteristics of other derivative financial instruments’ in respect of Sections C(7) and C(10) of Annex 1 to MiFID II.
Exemptions for commodity firms
Under MiFID, many entities trading commodity derivatives are able to rely on exemptions to avoid the need for authorisation as an investment firm. MiFID II will severely restrict those exemptions and will have a significant impact on firms that currently rely on them.
Dealing on own account exemption
MiFID II will amend the exemption on dealing on own account in Article 2(1)(d) of MiFID. A firm will no longer be able to rely on this exemption in relation to commodity derivatives, emission allowances or derivatives on emission allowances. However, if a firm is able to rely on the exemption in Article 2(1)(i) of MiFID II, it will automatically be able to rely on the new Article 2(1)(d) exemption in relation to dealing on own account in all other types of financial instruments.
MiFID II will significantly amend the ancillary exemption in Article 2(1)(i) of MiFID. It will only be applicable to activities in relation to commodity derivatives, EUAs or derivatives on EUAs and will only be available to firms which:
- deal on own account other than by executing client orders in commodity derivatives (although note that a recital suggests that the execution of orders as an ancillary activity between two persons whose main business on a group basis is not investment or banking services should not be considered to be dealing on own account by executing client orders); and/or
- provide investment services other than dealing on own account to the customers or suppliers of their main business.
In addition, those seeking to rely on the exemption will have to satisfy the following criteria:
- each of the permitted two activities, individually and on an aggregate basis, must be ancillary to their main business when considered on a group basis;
- that main business must not be the provision of investment services under MiFID, banking services under the BCD nor acting as a market maker in relation to commodity derivatives; and
- they must not apply a high frequency algorithmic trading technique.
Those relying on Article 2(1)(i) must notify the relevant competent authority on an annual basis that they make use of this exemption, and the relevant competent authority may request details of the basis on which they consider they have met these conditions.
Regulatory technical standards will set out the criteria for establishing when an activity is to be considered ancillary to the main business on a group level. They will at least take into account the need for ancillary activities to constitute a minority of activities at group level and the size of their trading activity compared to the overall market trading activity in the relevant asset class. There will however be carve outs from this in relation to certain intragroup trades, derivatives entered into for hedging purposes and derivative and emission allowance trades entered into as part of a liquidity provision obligation.
Commodity dealer exemption
The exemption in Article 2(1)(k) in MiFID that was specifically designed for persons trading in commodity derivatives will be deleted.
MiFID II also contains a new exemption for operators with compliance obligations under the Emissions Trading Directive5 where, when dealing in emission allowances, such persons do not execute client orders or provide any investment services or perform any investment activities other than dealing on own account, provided they do not apply a high frequency algorithmic trading technique. There are also exemptions for electricity and gas transmission system operators.
Each Member State will have the option to permit an exemption in relation to joint ventures set up by local electricity and/or natural gas undertakings and operators under the Emissions Trading Directive.
Practical consequences arising from revisions to the exemptions
Those commodity firms that currently rely on any of the exemptions in MiFID would be well advised to revisit and update their previous analysis. In particular, the new ancillary exemption will make it difficult for a regulated group to have an unregulated commodity derivative trading subsidiary and the removal of the commodity dealer exemption will put significant pressure on the agency trading structure that is used by many commodities groups and which allows a regulated entity to trade as agent on behalf of unregulated group companies. Where a firm is no longer able to rely on a MiFID II exemption as a result of the changes, it will need to become authorised to carry out the relevant MiFID II business and comply with the applicable rules relating to organisation, conduct and capital. For more information on these requirements please see our other briefings.
Even if an entity is able to continue to rely on an exemption, there are several important provisions in MiFID II and MiFIR that have a broader scope of application than just investment firms and the trading venues on which derivatives and emission allowances are traded. These include the new obligation to trade certain derivatives on a regulated market (RM), multilateral trading facility (MTF) or OTF or certain equivalent third country venues, as discussed in our briefing note on trading venues and market infrastructure.
Position limits and position reporting
MiFID II and MIFIR impose a number of key changes aimed at reducing systemic risk, combating disorderly trading and reducing speculative activity in commodity derivatives markets through the imposition of new position limit and management powers by trading venues and national regulators and the grant of additional intervention powers to ESMA.
The competent authority of each Member State will impose limits on the size of the net position which a person can hold in commodity derivatives traded on a trading venue and economically equivalent OTC contracts. They will apply to all positions held both by a person and on its behalf at an aggregate group level. Where the same commodity derivative is traded in significant volumes on trading venues in more than one jurisdiction, a single position limit may be set by the competent authority of the jurisdiction where the largest volume of trading takes place.
Position limits will not apply to positions held by or on behalf of a non-financial entity and which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity.
ESMA is tasked with developing a number of regulatory technical standards relating to the calculation and application of position limits in commodity derivatives.
The operator of a trading venue for commodity derivatives will also have to apply position management controls. These will include powers to monitor open interest positions; access information about the size and purpose of a position or exposure entered into, the beneficial or underlying owners, any concert arrangements and any related assets or liabilities in the underlying market; require a person to terminate or reduce a position on a temporary or permanent basis; and, where appropriate, require a person to provide liquidity back into the market.
The imposition of position limits and management controls will be a Member State responsibility and will be handled by the relevant competent authorities, although ESMA will be responsible for facilitating and coordinating national measures, including by publishing summaries of the position limits and management controls applied by competent authorities and trading venues on its website.
MiFID II introduces position reporting for commodity derivatives, emission allowances and derivatives thereof such that each trading venue is required to make public a weekly report of the aggregated positions held by the different categories of position holders (investment firms, investment funds, other financial institutions, commercial undertakings or, in the case of emissions allowances or derivatives thereof, operators with compliance obligations under the Emissions Trading Directive) for the different commodity derivatives traded on that trading venue. These will specify the number of long and short positions held by such categories, changes since the previous report, the percentage of total open interest represented by each category and the number of position holders in each category, when both the number of position holders and their open positions exceed minimum thresholds. There is also a separate obligation on the trading venue to provide its competent authority on at least a daily basis with a breakdown of the positions of all position holders, including the members or participants and their clients on that trading venue.
Investment firms trading in commodity derivatives, emissions allowances and derivatives thereof outside a trading venue must, on a daily basis, provide the relevant competent authority with a breakdown of their positions in commodity derivatives traded on a trading venue and equivalent OTC contracts, as well as those of their clients and the clients of those clients until the end client is reached.
In order to monitor compliance with position limits, members or participants of RMs, MTFs and clients of OTFs will have to report to the operator of the trading venue details of their positions held through contracts traded on that trading venue, as well as those of their clients and the clients of those clients until the end client is reached.
Position management powers of ESMA
MiFIR provides ESMA with position management powers allowing it to request all relevant information from any person regarding the size and purpose of a position or exposure entered into via a derivative. Having analysed this information, ESMA may require such persons to reduce the size of or to eliminate their position or exposure or, as a last resort, to limit the ability of a person from entering into a commodity derivative. ESMA can only take these steps if two conditions are satisfied: (i) there is a threat to the orderly functioning and integrity of the financial markets, including commodity derivative markets and including in relation to delivery arrangements for physical commodities, or to the stability of the whole or part of the EU financial system; and (ii) a competent authority has not taken measures, or the measures taken are inadequate, to address such a threat.
ESMA must ensure that any measure it takes neither creates a risk of regulatory arbitrage nor has a disproportionate detrimental effect on the efficiency of financial markets. As part of this, ESMA must consult the competent authorities and certain other bodies responsible for the physical markets. Any measures must be published on ESMA’s website and be reviewed at least every three months.
In addition, ESMA will have powers of supervision and intervention in relation to the marketing, distribution and sale of financial instruments or types of financial activity or practice